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The markets' cheapest stocks have been on a tear—and the value managers who buy them are taking advantage. But value is in the eye of the beholder, and investors should make sure they select a style they can stomach.

During the past three months, the S&P 500 Pure Value Index, which includes the stocks in the Standard & Poor's 500 with the strongest value characteristics, has returned 9% to the S&P 500's 7% return. Mutual funds that buy the cheapest large-capitalization stocks, meanwhile, have gained 8.6% during the same period, trumping both large-cap growth funds, which buy the market's fastest-growing stocks, and those that buy both.

The value label, however, can mean different things to different people—and the performance of mutual and exchange-traded funds devoted to such strategies can diverge dramatically depending on the market environment. Investors need to understand what they're getting and why. "There are many types of value managers," says Lew Altfest, chief investment officer of Altfest Personal Wealth Management in New York. "But they're all joined by the fact that they're motivated by cheap prices."

Value funds may all seem alike, but investors need to unwrap them and see what's inside before choosing a strategy.
Robert Neubecker for Barron's

Still, there are many different ways to define cheap. The simplest way is by their book-to-market ratio, a method used by Eugene Fama and Kenneth French in their research of the so-called value premium.

IN ITS SIMPLEST FORM, value investing means buying the cheapest stocks and waiting for the market to realize that they're bargains. Research has shown that this "deep value" investing works in the long term. According to data from Fama and French, since 1927, stocks with the lowest P/B have returned 3.3 percentage points a year more than those with a high P/B.

The
DFA US Large Cap Value
fund (DFLVX)—whose parent, Dimensional Fund Advisors, counts Fama and French among its board members—takes the 1,000 largest companies in the U.S. stock market and buys the cheapest 20% based on their P/B ratios. The fund has an average P/B of 1.17, according to Morningstar, well below the S&P 500's P/B ratio of 1.98. For investors who prefer active management,
Third Avenue Value
fund (TVFVX), which was founded by Martin Whitman, has a P/B of just 0.64, and has a history of looking abroad for value. The DFA fund gained 21.4% for the 12 months through April 2, while Third Avenue Value returned 16.2%. Both topped the S&P's 13.2% gain.

DEEP VALUE ISN'T for everyone. Some stocks are cheap for good reason, which means deep-value strategies that focus solely on one or two metrics will often sweep up some trash along with the treasure—and that can make for a bumpy ride. The DFA fund, for instance, has a three-year standard deviation, a measure of volatility, of 19.3, compared with the S&P 500's 15, while Third Avenue Value's volatility clocks in at 20.5.

That's why some investors prefer a manager who takes a "quality value" approach—buying stocks that look undervalued for one reason or another but have competitive advantages, strong balance sheets, and other characteristics that help separate the gold from the dross. "They want cheap stocks," says David Kathman, a fund analyst at Morningstar. "But they also want some good fundamentals." One example: the
Sound Shore
fund (SSHFX), which avoids the worst of the value stocks in favor of those that the managers think are better long-term bets than the market is giving them credit for. Sound Shore has gained 15.1% during the past year, with a three-year standard deviation of 17.9. The average stock in its portfolio has a P/B ratio of 1.2.

Sometimes, investors can even find value in growth funds. Altfest, for one, bought the
T. Rowe Price Mid-Cap Growth
fund (RPMGX) for his mutinous clients during the dot-com boom when value was trailing growth. The fund, however, focuses on reasonably priced growth stocks, making it a good choice for value-minded investors. It has gained 10.3% in the past 12 months, and its stocks have an average P/B ratio of 2.85 below its benchmark's 3.45.

There's one other value metric popular with investors—the dividend yield. These funds have had a run of popularity in the low-yield world created by the Federal Reserve's bond-buying, but the dividend yield is a classic value trait. The
T. Rowe Price Equity Income
fund (PRFDX), which is one of Kathman's favorites, buys cheap stocks that also pay a dividend. It has gained 15.6% in the past year and has a P/B of 1.64. It also has a three-year standard deviation of 15.4. "The equity-income type provides a bit more stability," Kathman says.

Ultimately, investors might want a bit of each style in their portfolio. "You can't have a narrow definition of value," Altfest says. "Or you'll miss opportunities."